Monday, January 13, 2014

Lockhart Greenlights Tapering

Atlanta Federal Reserve President Dennis Lockhart presented his 2014 forecast in a speech today. In short, he expects modestly better growth, ongoing improvement in labor markets, and inflation to gradually rise to the Fed's target. Pretty much the standard 2014 outlook, and with the usual caveats: There is still much progress to be made in labor markets, and inflation is currently on the low side. And, assuming all goes according to plan:

If all goes as expected, there is a policy transition under way from a QE world, so to speak, to a post-QE world. As I said, that decision was made in December.

Some of his more interesting comments come in the post-speech conversation with journalists. Michael Derby at the Wall Street Journal has the story. While the December employment number was a disappointment, it is not itself likely to deter policymakers from tapering plans:

...Mr. Lockhart told reporters what happened in the job market last month has not shaken his monetary policy outlook. “I don’t think we should overreact to one month” and should bear in mind employment data frequently undergoes notable revisions, he said.

Lockhart's views on stock prices are intriguing:

In response to audience questions, Mr. Lockhart rejected the idea that big gains in stock prices over the course of the last year mean the equities market has lost its moorings. When taking stock of what has happened, “I don’t see it as a bubble,” the official said, although he added he would like to see company earnings validate the advances the market has experienced. The official also said “we are watching very carefully to make sure we don’t get into bubble territory.”

He seems to be implying that he believes stock prices are reasonable only if earnings rise. Which is the same thing as saying he really doesn't believe that stock prices are exactly reasonable. They are just not sufficiently unreasonable to define as a "bubble." Combined with the careful "watching," one could interpret Lockhart as saying that the Federal Reserve believes stock markets are starting to get ahead of themselves. They are watching the financial stability issue like hawks...no pun intended.

Regarding the Evans rule, Lockhart admits what already should be evident to everyone:

...The Fed says that it will not raise short term interest rates until the jobless rate falls well under 6.5% so long as inflation remains contained. Mr. Lockhart said the fast approach to that level–unemployment was at 6.7% in December, from 7% the prior month– threatens to complicate the central bank’s message.

Rate hike guidance was supposed to be “easy” to understand, but given what’s happening, it will now require central bankers to have to explain more why they aren’t raising rates when the threshold is crossed, Mr. Lockhart said. He noted the Fed may need to revisit the guidance and refine it to deal with the current “challenges in communications,” and that may mean the central bank may need to make the jobless threshold less connected to the jobless rate.

The Evan's rule is defunct. Like I said yesterday, the Federal Reserve thought the Evans rule would be easy to understand, but the rapid drop in unemployment has greatly complicated their communications strategy. I like the part about making the jobless threshold less connected to the jobless rate. That is pretty much already the case. It seems increasingly evident that Fed communications strategy is at a major inflection point. Do they replace the Evans rule with fresh, specific numerical based guidance? Do they continue to specify labor market indicators? Does the statement get more or less wordy? And shouldn't these changes happen at the December meeting, rather than after unemployment plunges below 6.5%?

Moreover, wouldn't the Fed's communication strategy be easier if they just dropped mention of the employment mandate and focused on the inflation target? As Lockhard notes in his speech:

Over the past 12 months, inflation has averaged only 0.9 percent. Indeed, the broad patterns in the price data suggest we have been on a disinflationary trend for about two years, as shown in this slide.

Continued disinflation could pose risks to economic performance. This slide shows the trend of one key measure of inflation (the personal consumption expenditures inflation index) over the last four years. At the Fed, we follow a number of inflation indices, and they show basically the same picture.

The inflation situation shown here seems disconnected from the recent growth momentum and the outlook that it will continue.

As I mentioned earlier, I think inflation will stabilize and begin to move back in the direction of the FOMC's 2 percent objective as the economy gathers momentum. So I'm interpreting the soft inflation numbers as a risk signal. Through the lens of prices, the economy could be weaker than we currently believe.

The inflation rate alone gives them license to hold rates near zero without the complications of devining the message of the decline in the labor force participation rate. And he also suggests that low inflation is a signal that economic growth is weaker than commonly believed, again suggesting that there is no reason to rate rates.

So why not just focus on the inflation rate? I suspect because the Federal Reserve envisions the possibility that they may raise interest rates even if inflation is low. It's not the base case by any means (no rate hike until 2015 in the absence of real evidence of inflation is the base case), but it is something they don't want to ignore as well. An alternative situation is if unemployment declines further and the Fed fears they will fall behind the curve if they don't tighten. Another situation is that the Fed fears they will need to tighten policy to stifle potential bubbles. Indeed, the latter possibility probably already leads the Fed to hesitate before lowering the unemployment threshold.

In short, I think the Fed is looking to maintain maximum discretion with regards to rate policy; to the extent they want to find a new rule, it will almost certainly be a rule that, like the Evans rule, they were sure they would not want to break. In other words, they would like to find a rule that is clearly time consistent and easy to communicate. But as markets bubble and unemployment drops further, I think it is increasingly difficult for them to find such a rule. Suggestions anyone? And yes, I know one suggestion will be an NGDP target. I don't think the Fed is there yet.

Bottom Line: Another Fed speaker downplaying the December nonfarm payroll number, essentially giving the green light for another $10 billion cut in the pace of asset purchases. Pencil in $10 billion a meeting. But that's not really the big story at this point. The big story is the communications strategy. The era of transparency has arguably delivered only more complicated and confusing targets, thresholds, and statements. With the Evans rule turning into a pumpkin soon, they will need to decide if they want to double-down on this strategy or move onto something else. But what is that something else? Whatever it is, it must be near the top of incoming Chair Janet Yellen's to-do list.

Comments

Lockhart Greenlights Tapering

Atlanta Federal Reserve President Dennis Lockhart presented his 2014 forecast in a speech today. In short, he expects modestly better growth, ongoing improvement in labor markets, and inflation to gradually rise to the Fed's target. Pretty much the standard 2014 outlook, and with the usual caveats: There is still much progress to be made in labor markets, and inflation is currently on the low side. And, assuming all goes according to plan:

If all goes as expected, there is a policy transition under way from a QE world, so to speak, to a post-QE world. As I said, that decision was made in December.

Some of his more interesting comments come in the post-speech conversation with journalists. Michael Derby at the Wall Street Journal has the story. While the December employment number was a disappointment, it is not itself likely to deter policymakers from tapering plans:

...Mr. Lockhart told reporters what happened in the job market last month has not shaken his monetary policy outlook. “I don’t think we should overreact to one month” and should bear in mind employment data frequently undergoes notable revisions, he said.

Lockhart's views on stock prices are intriguing:

In response to audience questions, Mr. Lockhart rejected the idea that big gains in stock prices over the course of the last year mean the equities market has lost its moorings. When taking stock of what has happened, “I don’t see it as a bubble,” the official said, although he added he would like to see company earnings validate the advances the market has experienced. The official also said “we are watching very carefully to make sure we don’t get into bubble territory.”

He seems to be implying that he believes stock prices are reasonable only if earnings rise. Which is the same thing as saying he really doesn't believe that stock prices are exactly reasonable. They are just not sufficiently unreasonable to define as a "bubble." Combined with the careful "watching," one could interpret Lockhart as saying that the Federal Reserve believes stock markets are starting to get ahead of themselves. They are watching the financial stability issue like hawks...no pun intended.

Regarding the Evans rule, Lockhart admits what already should be evident to everyone:

...The Fed says that it will not raise short term interest rates until the jobless rate falls well under 6.5% so long as inflation remains contained. Mr. Lockhart said the fast approach to that level–unemployment was at 6.7% in December, from 7% the prior month– threatens to complicate the central bank’s message.

Rate hike guidance was supposed to be “easy” to understand, but given what’s happening, it will now require central bankers to have to explain more why they aren’t raising rates when the threshold is crossed, Mr. Lockhart said. He noted the Fed may need to revisit the guidance and refine it to deal with the current “challenges in communications,” and that may mean the central bank may need to make the jobless threshold less connected to the jobless rate.

The Evan's rule is defunct. Like I said yesterday, the Federal Reserve thought the Evans rule would be easy to understand, but the rapid drop in unemployment has greatly complicated their communications strategy. I like the part about making the jobless threshold less connected to the jobless rate. That is pretty much already the case. It seems increasingly evident that Fed communications strategy is at a major inflection point. Do they replace the Evans rule with fresh, specific numerical based guidance? Do they continue to specify labor market indicators? Does the statement get more or less wordy? And shouldn't these changes happen at the December meeting, rather than after unemployment plunges below 6.5%?

Moreover, wouldn't the Fed's communication strategy be easier if they just dropped mention of the employment mandate and focused on the inflation target? As Lockhard notes in his speech:

Over the past 12 months, inflation has averaged only 0.9 percent. Indeed, the broad patterns in the price data suggest we have been on a disinflationary trend for about two years, as shown in this slide.

Continued disinflation could pose risks to economic performance. This slide shows the trend of one key measure of inflation (the personal consumption expenditures inflation index) over the last four years. At the Fed, we follow a number of inflation indices, and they show basically the same picture.

The inflation situation shown here seems disconnected from the recent growth momentum and the outlook that it will continue.

As I mentioned earlier, I think inflation will stabilize and begin to move back in the direction of the FOMC's 2 percent objective as the economy gathers momentum. So I'm interpreting the soft inflation numbers as a risk signal. Through the lens of prices, the economy could be weaker than we currently believe.

The inflation rate alone gives them license to hold rates near zero without the complications of devining the message of the decline in the labor force participation rate. And he also suggests that low inflation is a signal that economic growth is weaker than commonly believed, again suggesting that there is no reason to rate rates.

So why not just focus on the inflation rate? I suspect because the Federal Reserve envisions the possibility that they may raise interest rates even if inflation is low. It's not the base case by any means (no rate hike until 2015 in the absence of real evidence of inflation is the base case), but it is something they don't want to ignore as well. An alternative situation is if unemployment declines further and the Fed fears they will fall behind the curve if they don't tighten. Another situation is that the Fed fears they will need to tighten policy to stifle potential bubbles. Indeed, the latter possibility probably already leads the Fed to hesitate before lowering the unemployment threshold.

In short, I think the Fed is looking to maintain maximum discretion with regards to rate policy; to the extent they want to find a new rule, it will almost certainly be a rule that, like the Evans rule, they were sure they would not want to break. In other words, they would like to find a rule that is clearly time consistent and easy to communicate. But as markets bubble and unemployment drops further, I think it is increasingly difficult for them to find such a rule. Suggestions anyone? And yes, I know one suggestion will be an NGDP target. I don't think the Fed is there yet.

Bottom Line: Another Fed speaker downplaying the December nonfarm payroll number, essentially giving the green light for another $10 billion cut in the pace of asset purchases. Pencil in $10 billion a meeting. But that's not really the big story at this point. The big story is the communications strategy. The era of transparency has arguably delivered only more complicated and confusing targets, thresholds, and statements. With the Evans rule turning into a pumpkin soon, they will need to decide if they want to double-down on this strategy or move onto something else. But what is that something else? Whatever it is, it must be near the top of incoming Chair Janet Yellen's to-do list.